A partnership is a business with several owners. Partnerships make a profit or incur a loss in the same way as other businesses, but there are some differences in the way a partnership functions that make its profits and losses different. from those of other types of businesses.
How Partnerships Make Money
The term "making money" to most people means making a profit. A profit is the difference between the income of the business and what it spends (expenses).
A business functions by spending money in order to sell products or services. A business also buys things (called "capital assets") to help make or sell these products or services. Then, at the end of a specified period of time, the expenses of the business are added together and compared with the income or revenue of the business.
If the revenue exceeds the expenses, the business has a profit (sometimes called "earnings" or "net income" for tax or legal purposes. If the revenue is less than the expenses, the business has a loss (or "net loss").
How Partners Get the Money
How the business makes a profit is the first step. Then look at the way the individual partners get their share of this money.
When a partner joins a partnership, the individual partner invests in the business and a capital account is set up for that partner. The way the partner's account is set up and how money is distributed to the partner is set in the partnership agreement. For example, a partnership two of two people might describe in the partnership agreement that each partner receives 50% of the profits (or any other percentage they agree on).
The partnership agreement describes when partners can take money out of the business (their distributive share) partnership (assuming there is money available for them to take!), according to the terms of the Each partner can take a draw (drawing money from his or her partnership account).
Partners are not employees, so the money they get from the partnership is not a salary and they don't get a W-2 form showing their annual taxable income.
How Partner Distributions Are Taxed
When a business makes money, the money goes to the owners, in the form of net income.
The partners are taxed on ALL of the income of the partnership each year, even if they don't receive any or all of the profits directly. Two equal partners in a partnership that has a $100,000 profit must each pay income tax on $50,000 of that profit.
After the end of the tax year, the partnership files an information return on Form 1065, showing the total net income or loss. Then each partner receives a Schedule K-1 showing his or her distributive share of this income or loss. The partner files the Schedule K-1 with the personal tax return.
Partner Taxes vs. Corporate Owner Taxes
A partnership is taxed differently from a corporation because, in a corporation, the profits are not distributed to the owners (shareholders) directly, but the owners may receive dividends. Usually, in a corporation, some of the profits are held (retained) by the business for growth.
Partners, LLC owners, and sole proprietors are considered pass-through entities for tax purposes because their share of the business profits is passed through to the owner's personal tax return.
Partner Taxes vs. Sole Proprietor Taxes
A sole proprietor, like a partner, is taxed on all the profits of the business. The sole proprietor completes a Schedule C to calculate the net income of the business, which is included in the total income of the owner.
Partner Taxes vs. LLC Owner Taxes
Limited liability companies (LLC's) with more than one member are taxed like and work like partnerships, except that owner titles are different, and the documents are different. LLC owners are called members. The members get together and create an operating agreement, which serves the same purpose as a partnership agreement.
LLC members receive funds during the year in the same way as partners, and according to the terms of the operating agreement. At tax time, the multiple-member LLC files its taxes in exactly the same way as a partnership, using the same forms.
An LLC with only one member is called a single-member LLC, and it is taxed like a sole proprietorship, on Schedule C of the owner's personal tax return.